Evaluating Target-Date Funds

ADVISER QUESTION: We are a registered investment adviser (RIA) firm that is hired by plans to provide fiduciary investment advisory services to committees for 401(k) plans. Many of our clients want to include target-date funds (TDFs) in the plan investment lineup. What should we consider in the process of evaluating target-date funds?

ANSWER: The Department of Labor (DOL) has issued guidance,­ “Target Date Retirement Funds—Tips for ERISA [Employee Retirement Income Security Act] Plan Fiduciaries,” about selecting and monitoring target-date funds.

Under that guidance, an adviser should first evaluate the characteristics of the covered employees to understand the plan demographics. Next, consistent with those demographics, the adviser should develop a recommendation about the asset allocation—i.e., the mix of asset classes and investment styles—and the glide path—i.e., the change in allocation as participants age.

The adviser should then evaluate a reasonable number of target-date funds with the asset allocations and glide paths suggested by the participant demographics. Finally, the adviser should look at commonly accepted investment metrics—fees and expenses, quality of the underlying funds, expense ratios of the TDFs (including the underlying funds), experience and qualifications of the investment manager and so on. Through this process, the adviser will identify one or more fund families with asset allocations, glide paths, underlying investments and expenses that are appropriate for the covered workers.

The DOL guidance suggests considering multiple demographic factors, including:

• Participation in another retirement plan offered by the employer, such as a defined benefit (DB) plan;
• Salary levels;
• Turnover rates;
• Contribution rates; and
• Withdrawal patterns.

However, fiduciaries have broad latitude in evaluating these variables. For example, if the employees covered by a 401(k) plan also participate in a pension plan, fiduciaries may want a target-date fund that has higher allocations to equities. Similar to a bond allocation, this would serve to balance the fixed nature of the pension benefits. Alternatively, a plan could select TDFs with a conservative allocation and glide path—on the theory that the benefits provided by the combination of the pension and 401(k) plans would be sufficient for most participants to have a comfortable standard of living in retirement, and therefore the TDFs should be designed to minimize investment risk.

Similarly, if the employer also sponsors an employee stock ownership plan (ESOP), an adviser may consider recommending target-date funds with conservative allocations—to balance the equities in the ESOP. Or, depending on the demographics of the work force, the fiduciaries may be able to find a basis to support a moderate, or perhaps even aggressive, allocation to equities in the funds.

The key is that the fiduciaries must investigate all of these issues to reach an informed, reasoned and documented conclusion.

The evaluation should also determine whether the glide path will go “to” or “through” retirement. If a plan covers an employee population that mostly cashes out at retirement, that suggests a target-date fund with a “to retirement” path. However, if the plan educates participants about the benefit of rolling over into an individual retirement account (IRA) with the same TDF family or a similarly designed glide path, that might support selection of a “through retirement” glide path.

In its guidance, the DOL also noted that plan fiduciaries should “inquire about whether a custom or nonproprietary target-date fund would be a better fit.” A custom TDF is one that consists of the funds in the plan’s core lineup—although, in some cases, it is possible to include other funds. With a custom TDF composed of the plan’s core lineup, the underlying funds will, presumably, have been prudently selected and monitored. However, advisers would still need to evaluate whether the custom target-date fund aligns with the asset-allocation and glide-path structure appropriate for the covered workers.